This blog makes an attempt to demystify the topic stress testing.

A banking organization holds capital to guard against uncertainty. Capital reassures an institution’s depositors, creditors and counterparties‐‐and the institution itself‐‐that an event such as an unexpected surge in losses or an unanticipated deterioration in earnings will not impair its ability to engage in lending to creditworthy borrowers and protect the savings of its depositors.

The assessment and monitoring of strengths and vulnerabilities of financial systems is called macro prudential analysis. Macro prudential analysis uses quantitative information on the financial system as well as qualitative information on the institutional and regulatory frame work.

It encompasses surveillance of financial market conditions and analysis of macro financial linkages. It is in turn part of a broader framework of macroeconomic vulnerability assessment, which includes the balance sheet approach, debt sustainability analysis and monitoring of macroeconomic conditions.

One of the key techniques for quantifying financial sector vulnerabilities is stress testing. The term stress testing refers to a range of statistical techniques used to help assess the vulnerability of a financial system to exceptional but plausible events.

System-wide stress tests (or macro financial stress tests) measure the impact of shocks on financial system stability.

Compared to stress tests for individual financial institutions, the system-wide stress tests have—as the name suggests—wider coverage (i.e. the financial system or a systemically important part of it), are used for a different purpose (financial sector surveillance rather than risk management), focus more on channels of contagion (i.e. how a risk to one institution can become a systemic risk), and often have to use more streamlined techniques (because of the ensuing complexity of the calculations).

Also, system-wide stress testing is a much newer concept, and the literature on the topic is consequently much shorter than that on stress testing for individual institutions.

Stress tests can be classified, by methodology, into three main types: (i) sensitivity analysis, which seeks to identify how portfolios respond to changes in relevant economic variables (such as interest rates and exchange rates); (ii) scenario analysis, which seeks to assess the resilience of financial institutions and the financial system to an exceptional but plausible scenario; and (iii) contagion analysis, which seeks to take account of the transmission of shocks from individual exposures to the financial system as a whole.

The importance of stress testing for macro prudential analysis derives from integrating a forward looking macroeconomic perspective, a focus on the financial system as a whole, and a uniform approach to the assessment of risk exposures across banks.

Unlike the stress tests conducted at large banks, which are designed to measure portfolio- and bank-specific risk exposures, system wide stress tests apply a common set of scenarios based on an assessment of macroeconomic and market risks. This uniform approach allows for the aggregation of results, helping to identify key vulnerabilities at the level of the overall system, and providing comparable information on risk profiles across banks.

Stress testing is primarily about identifying latent exposures. There is little need to perform complicated stress test calculations if the exposures are obvious, or obviously lacking. Stress tests are needed to identify exposures that are less obvious, perhaps hidden across a wide variety of instruments, credits, and derivatives positions.

System-wide stress testing can be viewed as a multi-step process of examining the key vulnerabilities in the system. This involves: identifying the major risks and exposures in the system and formulating questions about those risks and exposures; defining the coverage and identifying the data required and available; calibrating the scenarios or shocks to be applied to the data; selecting and implementing the methodology; and interpreting the results.

To be relevant, stress tests must probe the consequences of potential shocks that are related to the macroeconomic risks that exist in the actual situation of the country. The process of designing system-wide stress tests therefore typically starts with a discussion of the potential risks faced by the economy. The discussion then suggests that certain types of shocks (e.g. a potential increase in interest rates or a depreciation of the currency) are more likely in the given economy than other types of shocks.

The fact that there are macroeconomic risks that could result in shocks to the financial system does not necessarily mean that the impact of the shocks would be large. The impact can still be small if the exposures in the system are small. It is the purpose of the stress tests to assess how the risks combine with the exposures. The design of stress tests is often an iterative process, since some originally identified risks may lead to relatively small impacts, while some risks originally assessed as small may lead to large impacts if there are substantial exposures.

Even if the exposures are large and stress tests identify a potentially large impact on the financial system, it is the purpose of the other parts of the macro prudential analysis to assess the likelihood that these impacts can be mitigated by prompt action by supervisors and banks.